Verizon: Undemanding Valuation And 4.5% Yield Makes It A Buy

Summary

Verizon continues to benefit from its leadership position on mobile but competition is catching up.

Over the next few quarters, there is the risk Verizon's growth will slow down due to pricing war in the sector.

This risk seems to be already priced in as Verizon is only trading at 13.4x 2014 earnings, at discount to the S&P 500 index.

It also has an above-average dividend yield of 4.5%, making it an attractive income investment over the long term.

High-dividend yields may be good opportunities or dividend traps because generally a dividend yield, which is considerably above average, may be considered a warning sign for income investors. Therefore, it is extremely important to analyze the company's fundamentals to see if there exists undervaluation, reflected in the unusually high-dividend yield, or if dividend cut risk is the reason why the yield is so high.

In the telecoms sector, there exist plenty of high-dividend yielders but not all are created equal. Fixed-line operators like Windstream (NASDAQ:WIN) or Frontier Communications (NASDAQ:FTR), face strong headwinds as customers increasingly switch to mobile phones. Therefore, these companies offer high yields, but are clearly risky due to deteriorating business fundamentals over the long term. On the other hand, the large carriers AT&T (NYSE:T) and Verizon Communications (NYSE:VZ) are among the few exceptions in the marketplace, offering high-dividend yields that are clearly safe. Previously, I've covered AT&T and in this article I review Verizon's investment case.

Company Overview

Verizon Communications is one of the world's leading providers of communications, information and entertainment products and services to consumers, businesses and governmental agencies, with a presence in over 150 countries around the world. Verizon was formed on June 30, 2000, with the merger of Bell Atlantic Corp. and GTE Corp. The company is listed on the New York Stock Exchange and has a market capitalization of $195 billion. It has approximately 178,000 employees. Verizon competes with all major domestic providers of wireless communication services. Its primary competitors are AT&T, Sprint (NYSE:S), and T-Mobile (NYSE:TMUS), but it also faces competition from regional carriers and other providers of voice, video, and data transport services.

The company's business is split into two reportable segments, Wireless and Wireline. Its Wireless business is the company's largest, accounting for more than 67% of its revenues and about 80% of its EBITDA. This weight is expected to increase over the coming years, as mobile enjoys higher growth than fixed-line services. The company ended 2013 with more than 100 million mobile customers. In 2013, Verizon has reached an agreement to purchase the portion of Verizon Wireless owned by Vodafone (NASDAQ:VOD) for an amount of $130 billion, giving it the full ownership of its wireless business. The transaction was completed on 21 February 2014, in a mixture of cash payment and Verizon common stock. Although this has increased Verizon's indebtedness, the transaction should be accretive to Verizon's earnings by about 10%.

Over the past few years, Verizon has invested significantly in its network quality and has substantially completed the deployment of its fourth-generation [4G] Long-Term Evolution [LTE] network. The 4G LTE network is currently available to about 97% of the U.S. population in more than 500 markets, covering approximately 305 million people. Verizon's network is perceived as high quality and is a major competitive advantage over its peers. It is also one of the most important factors why the company has been able to gain more customers than competitors over the past few months. This is also reflected in its low churn ratio, which was only 1.27% in 2013. However, AT&T is also pushing for network quality and is closing the gap, while T-Mobile is using its acquisition of MetroPCS to improve its network and Sprint is spending about $8 billion per year to catch-up on network quality. Therefore, Verizon should continue to have an edge over the next few months based on network quality, but pricing should become more important to retain customers after the current network investment phase. This has been already visible on Verizon's recent price cuts, demonstrating that no one is immune to a price war. Verizon announced new "More Everything" plans, which effectively reduce the price for data, includes unlimited international messaging from the U.S. and free cloud storage for the account. This should be dilutive to Verizon's average revenue per user [ARPU] and clearly is a headwind for revenue growth for the next few quarters.

Regarding its financial performance, despite fierce competition from its three main competitors and the company's large size, Verizon has reported relatively strong growth over the past few years. In 2013, Verizon's revenues increased by 4.1% to $120.6 billion. Wireless service revenue was up by 6.8%, while Wireline revenue shrank by 1.5%. The company continues to push smartphones and tablets to its customers, which leads to higher data usage. Data is currently the main source of revenue growth for telecom carriers, explaining why Verizon paid so much to obtain full control of its wireless business. About one-third of its customers don't have smartphones, so Verizon still has good growth prospects on increased data usage.

Going forward, Verizon's revenues are expected to rise by 3.8% in 2014 and by 3% in 2015. This growth isn't impressive but is better than its closest competitor AT&T, which should increase its revenues by only 2.6% in 2014 and 1.5% in 2015. Verizon does not see the current competitive landscape to be materially different from the past, and continues to emphasize the competitive strength of its network. However, Sprint and T-Mobile completed transactions in 2013 to improve their ability to compete with AT&T and Verizon, so industry competition should remain fierce, and should continue to be a negative risk for Verizon's growth over the next few years.

Verizon's profitability is quite good, reflecting its exposure to mobile. The company's overall EBITDA was $42 billion in 2013 or an EBITDA margin close to 35%, with Wireless reporting an EBITDA margin of 50% and Wireline only 22%. This compares well with AT&T, which had an EBITDA margin of 32% in the past year, due to its higher reliance on wireline. As Wireless should continue to increase its weight within the group, Verizon is expected to continue to improve its profitability. By 2016, its EBITDA should amount to $48.6 billion and its margin is estimated to be around 37%.

Dividends

Verizon has a good dividend history, at least over the past few years. Verizon's quarterly dividend was increased by 2.9% during 2013, making this the seventh consecutive year in which the company raised its dividend. Over the past five years, Verizon's dividend compounded annual growth rate [CAGR] was 2.8%, which is not particularly impressive but nonetheless is above AT&T's dividend growth rate (CAGR of 2.4%) during the same period.

Its current quarterly dividend is $0.53 per share, or an annual dividend of $2.12. At its current stock price, Verizon has an attractive dividend yield of 4.5%. However, even though this yield is attractive it's not among the highest in the telecom sector and is below its closest peer AT&T, which yields above 5%. Its dividend payout ratio was 74% in 2013 based on adjusted EPS of $2.84, a high payout ratio, but acceptable for a mature and highly profitable company like Verizon.

Verizon has invested significantly on its mobile network and has replaced its copper wire with fiber-optic cable to maintain is network leadership, resulting in high capital expenditures [capex] over the past few years. In 2013, its capex amounted to $16.6 billion or 13.8% of its revenues. The company expects capex in 2014 to be in the range of $16.5-$17 billion, a level that should reduce to slightly above $16 billion in 2015 and 2016. This means its free cash flow generation should continue to increase over the next few years, due to the combination of higher revenues and margins and lower capex outflows.

In 2013, its free cash flow amounted to more than $22 billion, showing how strong Verizon's cash generation capacity is. Its payout ratio based on cash flows, which may the best measure to assess its dividend sustainability, is only about 26%. This ratio is quite low and much lower than the sector's average, so even though its yield is not as high as some of its competitors it appears to be much safer.

After the acquisition of Vodafone's stake in Verizon Wireless, the company's indebtedness has increased significantly. Verizon's balance sheet leverage continues to be acceptable at about 2.4x (net debt to EBITDA), but is much higher than 1x at the end of 2013 and above AT&T's 1.7x leverage. Deleveraging is a priority for the company, as it plans to return to a single-A credit rating in the next 4-5years. Therefore, it seems that dividends are the only planned cash return to shareholders, thus it should not conduct any share repurchases in the next 2-3 years.

Conclusion

Verizon's leadership position and higher network quality have enabled it to report strong growth over the past few years. However, competition is catching up and the competitive landscape can turn more demanding going forward, leading to slower growth than in the recent past. Verizon is trading at only 13.4x its estimated 2014 earnings, and below the valuation of the S&P 500 index. AT&T is basically trading in-line with Verizon at 13.2x 2014 earnings. This relatively undemanding valuation reflects the risks that the wireless business could slow due to increasing competition.

However, this seems to be already priced in, so Verizon appears to offer value for income investors over the long term. Verizon has a dividend yield lower than AT&T, but its growth prospects are slightly higher and has a more secure dividend stream over time. As both companies are trading at the same valuation, I prefer Verizon at these levels over AT&T.

Disclosure: I am long T, VZ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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